ECON 304

Money and Banking

Instructor: Bernard Malamud
–Office: BEH 502
Phone (702) 895 –3294
Fax: 895 – 1354
»Email: bernard.malamud@unlv.edu
Website: www.unlv.edu/faculty/bmalamud
Office hours: MW 11:30 - 12:30 pm; 2:30 – 3:30 pm;
and by appointment
 Money, Banking, Financial Markets and Crisis
• The role of money and monetary policy in the
economy
TRUST
• How financial markets such as bond, stock and
foreign exchange markets work
TRUST
• How financial institutions such as banks and
insurance companies work
TRUST
 Course Objectives
• Roles played by banks and other intermediaries
• Determination of asset prices in financial markets
• How financial institutions operate
– Asymmetric information
• Adverse selection/Moral hazard/Principal – Agent Problems
– Innovations
– Regulation
• The conduct and impacts of monetary policy.
– How policies can promote macroeconomic stability
• Understand and explain the roots, responses and
consequences of the subprime-triggered financial
crisis.
Texts
Frederic S. Mishkin, The Economics of Money, Banking and Financial Markets,
10th edition. Earlier editions work…but read Ch 9 of 9th & 10th ed.
Financial Crisis Inquiry Commission Report
Supplemental Books and Articles (see course outline):
• Frank Partnoy. Infectious Greed: How Deceit and Risk Corrupted the Financial Market, 2003
• Gillian Tett, Fool’s Gold. 2009.
• David Wessel, In Fed We Trust: Ben Bernanke’s War on the Great Panic, 2009.
• Andrew Ross Sorkin, Too Big to Fail. 2009.
• Simon Johnson and James Kwak, 13 Bankers : The Wall Street Takeover and the Next
Financial Meltdown. 2010
• Henry Paulson, On the Brink, 2010.
• Raghuram G. Rajan, Fault Lines. 2010.
• Joseph Stiglitz, Freefall. 2010.
• Perry Mehrling, The New Lombard Street. 2011.
• Gretchen Morgenson and Joshua Rosner, Reckless Endangerment. 2011.
• Neil Barofsky, Bailout. 2012.
• Articles in Journal of Economic Perspectives (JEP) and Federal Reserve System publications
cited in this outline and as added as the semester proceeds. These can be accessed from
the JEP and Federal Reserve Bank websites.
 M & B Talk
Some Terms
Liquidity/solvency
Shadow banking system
Structured Investment Vehicles (SIVs)
“This time is different” … Irrational exuberance
Systemically important financial institutions (SIFI)
“Too Big to Fail” … Too Big to Bail
Discount window stigma
Term Auction Facility (TAF)/Term Security Lending Program (TSLP)
Primary Dealer Credit Facility (PDCF)/Money Market Investor Funding Facility (MMIFF)
Asset Backed Securities (ABS/MBS)/Credit Default Swaps (CDS)
Troubled Asset Relief Program (TARP)
Lender of Last Resort
Stress test
“Large negative tail”  Black swan
 Development and Recent Past of the Financial System
• http://ineteconomics.org/video/full-video/recent-past-finance-adair-turner
Some Basics of Money, Banking and Financial Markets
• A security (financial instrument) is a claim on the
issuer’s future income or assets
• A bond is a debt security that promises to make
specified payments over time
– An interest rate is the cost of borrowing or the price paid
for the rental of funds

• Common stock represents a share of ownership in a

corporation
– A share of stock is a claim on the earnings and assets of
the corporation
 M & B Pictures
Interest Rates on Selected Bonds, 1953–2011

Sources: Federal Reserve Bulletin; www.federalreserve.gov/releases/H15/data.htm.

 Stock Prices as Measured by the Dow Jones
Industrial Average, 1950–2011

Source: Based on Dow Jones Indexes: http://nance.yahoo.com/?u.

 Understanding Financial Distress I
… credit routinely turned over … but in crunch …
Background Concepts
• Flavors of liquidity
Funding liquidity  “haircut” on collateral
Market liquidity  fire sale in crisis
• Lending channel (turn to banks)
– Moral hazard  monitoring cost
When borrower net worth down … don’t lend
– Precautionary hoarding by intermediary
• Network effects: everyone a borrower & lender/no netting
When counterparty credit risk up … GRIDLOCK
• Silent run
… loans not renewed
 Connectivity and Amplification

Reduced
Positions

Fire Sale

Initial Funding
Initial Losses Falling Prices
Losses Problems

Higher Margins

Losses on
Existing Assets
 A “Global Saving Glut”
The best
of times

Capital Inflows

Easy Escalating
Money House Prices
Policy

Eager Home
Ambitious Buyers
Mortgage Brokers
Developer Clout
Innovative
Banks

Securitization Rating
Gov’t Sponsored MBSs Agencies
Bank Regulators
Enterprises
 The best
of times

Capital
Inflows

Easy Escalating
Money House Prices
Policy

Eager Home
Ambitious Buyers
Mortgage Brokers
Developer Clout
Innovative
Banks

Securitization Rating
Gov’t Sponsored
Bank Regulators Enterprises MBSs Agencies
Underlying Innovations
• Securitization
• SIVs (Structured Investment Vehicles)
• Ratings bias
• ARMs, teaser rates, no-doc loans, NINJA loans
Episodes
• American Home Loan, PNB Paribus hedge fund failures
 TED rate jump  ECB, Fed Injections (TAF)
• Monoline insurers (of MBSs) downgrade
 Impact on money market funds
• Carlyle failure  run on Bear (March 2008)
 Fed backed JP Morgan takeover/TSLF for investmt banks
• September 2008: Lehman, Merrill, AIG  TARP
 Responses Lender of Last Resort / Spender of Last Resort
• Tax Rebate $124 bil.
• Fed Fund Rate Cuts
• Fannie/Freddie $200 bil.
• Bear-Stearns $29 bil.
• AIG $174 bil.

Fed “Facilities”
• Primary Dealer Credit Facility (PDCF) $58 bil.
• Treasury Security Loan Facility (TSLF) $133 bil.
• Term Auction Facility (TAF) $416 bil.
• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.
• Money Market Investor Funding Facility (MMIFF) $540 bil.
• More Fed Fund Rate Cuts … Hold At ~0%
• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.
• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.
• Emergency Economic Stabilization Act/TARP $700 bil.
Government Loans
Government Equity
• Stimulus Package $787 bil.
aka The American Recovery and Reinvestment Act
• TARP II
• Stress Tests
 Money Growth (M2 Annual Rate) and the Business Cycle
in the United States 1950–2011
Monetary Theory ties changes in the money supply to
changes in aggregate economic activity and the price level
 Money Growth (M2 Annual Rate) and Interest Rates
(Long-Term U.S. Treasury Bonds), 1950–2011

• Prior to 1980, the rate of money growth and the interest rate
on long-term Treasury bonds were closely tied
• Since then, the relationship is less clear but the rate of
money growth is still an important determinant of interest
rates
Aggregate Price Level and the Money Supply in the
United States, 1950–2011
 Average Inflation Rate Versus Average Rate of
Money Growth for Selected Countries, 2000-2010

Source: Based on International Financial Statistics. www.imfstatistics.org/imf.

 Monetary and Fiscal Policies
• Monetary policy is the management of the money supply
and interest rates
– Conducted by the Federal Reserve Bank (Fed)
• Fiscal policy is government spending and taxation
– Any deficit must be financed by borrowing …
government borrowing affects interest rates
Macro Facts: Bank Excess Reserves
M1/Monetary Base=M1/(Currency + Reserves)
 Core Principles of Money and Banking
• Time has Value  Interest rate
• Risk Requires Compensation
• Financial decisions are based on
Information and TRUST
• Markets set prices and allocate resources
• Stability reduces risk and spurs enterprise
• Uncertainty  Fear  Enterprise
 Function of Financial Markets
• Channel funds from economic players that have
saved surplus funds to those that have a shortage
of funds
• Promotes economic efficiency by producing
an efficient allocation of capital
– increases production

• Improves consumer well-being

– allows them to time purchases better
 Structure of Financial Markets
• Debt and Equity Markets
• Primary and Secondary Markets
– Investment Banks underwrite securities in primary markets
– Brokers and dealers work in secondary markets
• Exchanges and Over-the-Counter (OTC) Markets
• Money and Capital Markets
– Money markets deal in short-term debt instruments
– Capital markets deal in longer-term debt and
equity instruments
Principal Capital Market Instruments
 Internationalization of Financial Markets
• Foreign Bonds—sold in a foreign country and
denominated in that country’s currency
• Eurobond—bond denominated in a currency other than
that of the country in which it is sold
– Perhaps in the future a bond backed by all eurozone countries
• Eurocurrencies—foreign currencies deposited in banks
outside the home country
– Eurodollars—U.S. dollars deposited in foreign banks outside
the U.S. or in foreign branches of U.S. banks
• World Stock Markets
Function of Financial Intermediaries: Indirect Finance
• Lower transaction costs
– Economies of scale
– Liquidity services
• Reduce Risk
– Risk Sharing (Asset Transformation)
– Diversification
• Asymmetric Information
– Adverse Selection (before the transaction)—more likely to select
risky borrower
– Moral Hazard (after the transaction)—less likely borrower will
repay loan
 Banking and Financial Institutions
• Financial Intermediaries—institutions that borrow funds
from people who have saved and make loans to other
people and businesses
• Banks—accept deposits and make loans
• Other Financial Institutions—insurance companies,
finance companies, pension funds, mutual funds and
investment banks
• Financial Innovation
– The information age and e-finance
– Derivatives … bubbles and crisis
– Securitization … bubbles and crisis
Principal Financial Intermediaries and Value of Their Assets
 Regulation of the Financial System

• To increase the information available to investors:

– Reduce adverse selection and moral hazard problems
– Reduce insider trading
• To ensure the soundness of financial intermediaries:
– Restrictions on entry
– Disclosure
– Restrictions on Assets and Activities
– Deposit Insurance
– Limits on Competition
– Restrictions on Interest Rates